From the May 2006 issue of Entrepreneur

Most business owners still in their operating prime would rather not think about handing over the family business to the next generation--at least not until they're ready to retire. By then, though, it may be too late to come up with the kinds of tax-saving strategies that could save your heirs a bundle later on.

"The earlier you start, the better," says Sanford J. Schlesinger, an estate attorney with Schlesinger, Gannon & Lazetera in New York City. That's partly because your company is likely to be worth less earlier on, so it will cost less taxwise to transfer it earlier. If you wait until your $1 million business has grown to $50 million, gifting it to your children will cost millions in gift tax. Worse yet, if you leave it to them at your death, they might just have to sell the business to cough up the estate tax.

Since that's the last thing you want, consider doing a little advance planning now to make sure your business stays in the family. One option is to begin transferring percentages to your heirs upon your business's inception, says Schlesinger. For example, keep 70 percent of the business for yourself-retaining complete control over day-to-day operations--and create a trust for each of your three children, putting 10 percent of the business in each. You'll still owe gift tax, but because each trust holds a minority share in a private, illiquid company, you'll save a considerable amount of money--anywhere from 20 percent to 45 percent, he says. "The value of that 10 percent might be small now," says Schlesinger, "but 10 years from now, it could be worth a fortune."

You can also sell discounted shares to your kids for either cash or promissory notes at a low, legal interest rate. "That's essentially lending your kids money to buy interest in the business," says Schlesinger. He adds that thanks to IRS code 6166, if your active business constitutes more than 35 percent of your adjusted gross estate and you own more than 20 percent of the company's voting shares, your heirs can pay estate tax in installments over 14 years-and pay only interest for the first five. "That's one of the greatest planning techniques there is," he says.

Another creative move is the "charitable bailout," says Wayne Rivers, president of the Family Business Institute in Raleigh, North Carolina. This technique allows you to transfer the entire business to a charitable remainder trust, which pays income to designated beneficiaries during their lifetimes and donates the remainder to charity upon their deaths. Your business goes in trust, and your children buy a life insurance policy for you. At your death, they use the life insurance proceeds to buy the business from the trust. "It avoids taxation and puts the business in the hands of the family members who can truly handle it later on," says Rivers.

That raises one of the dangers of early maneuvers. Giving away equal shares to all three children may seem equitable now, but if only one ends up working in the business, he or she may feel cheated by the fair split. That kind of setup can spell disaster for the business and for family relations. "Bickering in the family business is more likely to destroy it than the estate tax," says Schlesinger, who typically recommends clients retain at least 51 percent of the business until they're sure of which child is up for the job. If only one child will be an active participant, the others can be compensated with proceeds from life insurance or with other assets.

Any plan should be developed with a qualified estate attorney who has ample experience with family businesses, and it must balance your tax needs with particular family issues. Placing the company in an irrevocable trust, for example, might save on estate tax, but you may not want your kids to clean up so early. Says Jennifer Jordan McCall, an estate planning attorney and partner at Pillsbury Winthrop Shaw Pittman in Silicon Valley, "If they know at [age] 35 they're going to get a third of $10 million, it can take away their incentive to work."

C.J. Prince is a New York City writer specializing in business and finance.